Recapitalization and the Implicit Treasury Guarantee

Treasury equity is not the same as debt to the Fed, but are they so different? In some ways the Fed’s I-can’t-just-stop-rolling-it-over-when-I-want contribution is a bit like preferred equity.

I think main key difference is one of credit risk. If Big Bank has access to the Fed’s liquidity facilities, that’s all well and good, but doesn’t protect Big Bank’s creditors (just ask anybody who lent money to WaMu). On the other hand, if Big Bank is state-owned, there’s an implicit government guarantee on its liabilities: the German word for it is Anstaltslast.

We’ve already learned with AIG that once Treasury takes a large equity stake in a company, it will extend as much credit as necessary to keep that company going. Now Treasury owns 80% of AIG; maybe it wouldn’t make the same decision with Morgan Stanley, say, if its equity stake was much smaller than that.

But if Morgan Stanley does get a Treasury equity injection, I’m pretty sure the stake will end up being a majority one. Treasury would need to inject much more money than MUFG’s $9 billion before the market even started getting reassured about Morgan Stanley’s viability — and the bank’s entire market capitalization right now is only $8 billion.

And once Treasury has a majority stake, I think bondholders are safe. Otherwise, what’s the point of taking that majority stake in the first place?

Once bondholders are safe, of course, the institution in question will be able to start tapping the interbank markets again. And that could help the entire banking system.

But why do this on a case-by-case basis? A blanket government guarantee of all banking-sector liabilities should have the same effect. Just like the initially-conceived TARP was overtaken by events and became an equity-injection device, the plan to take equity stakes could well be overtaken by this weekend’s meetings and become a universal guarantee instead. (Of course, such a guarantee should absolutely be accompanied by equity stakes in banks, otherwise the government has all downside and no upside.)